One of the best mutual fund managers of the past decade is Bruce Berkowitz, who manages the Fairholme Fund and its $10 billion in assets. Year-to-date, Berkowitz's fund is up more than 28%, 10% better than the S&P 500. One of his main criteria for buying stocks is free cash flow yield, which he likes to see above 10%. However, it's not enough to have great cash flow. A company must use that free cash flow intelligently, either by rewarding shareholders through share repurchases and dividends or by making acquisitions that are accretive to earnings. In the end, a company's responsible stewardship of shareholder capital will usually result in its stock appreciating. But remember, like all valuation metrics, it's not perfect. There will always be exceptions to the rule.
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Consumer Staples and Free Cash Flow
To demonstrate the usefulness of free cash flow yield, the stock screen below shows consumer staple stocks that are of a reasonable size (market cap greater than $500 million) and financially sound. Those with long-term debt greater than $500 million and EBITDA less than $500 million were excluded.
| 5 Leading Consumer Staples Companies |
|
Company
|
Market Cap
|
FCF Yield
|
FCF/Sales
|
|
Nike (NYSE:NKE)
|
$31.1 billion
|
5.33%
|
8.94%
|
|
Coach (NYSE:COH)
|
$11.0 billion
|
5.17%
|
17.61%
|
|
Ralph Lauren (NYSE:RL)
|
$7.7 billion
|
6.79%
|
10.61%
|
|
Hormel Foods (NYSE:HRL)
|
$4.7 billion
|
6.70%
|
4.68%
|
|
Lorillard (NYSE:LO)
|
$13.0
|
5.89%
|
16.48%
|
A Little Wrinkle
If you look at the table above, you'll see that all five companies are within a very tight range. The difference between Ralph Lauren's yield of 6.79% and Coach's 5.17% is just 152 basis points. Based strictly on yield, there's no clear-cut winner. Therefore, free cash flow margin has been added to the quantitative portion of this analysis, which, when multiplied by free cash flow yield, generates a product in which the higher the number, the better. In this scenario, the obvious winner is cigarette manufacturer Lorillard, followed by handbag maker Coach, with meat and food products company Hormel finishing at the bottom. What does all this mean? All five do an exceptional job creating free cash. To reach a decision, we still need to assess each company's use of those funds.
Share Buybacks and Other Goodies
Lorillard was spun-off from Loew's Corp. (NYSE:L) in June, 2008. Since then, its stock is up 9%, compared to negative returns of 21.1% and 27.4% for the S&P 500 and Loews respectively. Loews shareholders definitely benefited from the spin-off. At the time, Loews exchanged its 38% interest in Lorillard stock for an equivalent amount of Loews shares. Loews reduced its number of shares outstanding, while shareholders got a better return on their investment over the next 16 months. It was a win-win situation. How is Lorillard using its free cash flow today? In the trailing twelve-month period, it has spent $546 million for share repurchases and $622 million in dividend payments, returning over $1.17 billion in cash flow to shareholders. In the second quarter alone, its share repurchases - $146 million at an average price of $67.67 - achieved a return on investment of 15.2%. With only $50-60 million in capital expenditures in 2009, expect more of the same in the second half of the year. You gotta love it.
Coach's fiscal year ended June 30. During the latest twelve-month period, it repurchased $453.8 million in shares at an average price of $22.51, generating a 53.3% return on its investment. As for dividends, it only started paying a quarterly dividend of 7.5 cents in June of this year. The yield is less than 1% at current prices. In 2009, it spent $240 million in capital expenditures. In 2010, management expect it to be less than half or approximately $110 million. Given this information, expect free cash flow in the coming year to be higher than the $569 million it generated in 2009, delivering a higher free cash flow yield. You might say it's in the bag.
The Bottom Line
While Coach's net income excluding unusual items dropped 21% in its fourth quarter, 2010 will be a winner for the upscale retailer. For this reason, take Coach stock over Lorillard, unless you're an income investor and then you'll have to consider whether you want a cigarette manufacturer in your portfolio, regardless of the 5.1% yield. It's terrible having a conscience. (To learn more, read Free Cash Flow: Free, But Not Always Easy.)
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